Welcome to the Cleared Swaps World – Sign Here, Please
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The final wave of the swaps clearing mandate will hit in September. But entering into a clearing agreement doesn’t mean swaps trading will be risk-free, as CCPs hold the potential to be an extraordinarily risky part of the market.
As the last customer types prepare for the clearing of swaps in September, people are becoming more aware of the implications of clearing agreements and the relationships among the customer, his FCM and the CCP. However, there are a few reasons to be particularly careful in executing clearing agreements.
As a bit of background, the requirement to use CCPs actually serves to concentrate counterparty risk, at least for large players. Imagine a swap dealer (SD) that has $100 billion in exposure to 1,000 separate counterparties, converting that to $50 billion in exposure with each of two CCPs. Clearly, there has been a significant concentration of risk. Not a problem if the CCP is risk free; but a potential problem if it isn’t.
[Related: “A Familiar Model Emerges for Swaps”]
Now let’s look at the market – not the market for swaps or even clearing services, but the market for CCPs themselves. If a significant number of CCPs are chasing a finite volume of clearing, we might expect them to find ways to compete. One of those ways might be in initial margin, particularly on bespoke products. This “race to the bottom,” if it surfaces, could easily make CCPs an extraordinarily risky part of the market.
Finally, we need to understand the nature of financial panics. They always begin as muffled rumblings in the distance – trouble for someone else but not for us. Then the trouble spreads, and the market starts buzzing with rumors. At some point, the trouble reaches a tipping point, and everyone rushes to get out. At that point, it may be too late to save anyone’s bacon, no matter whom they clear through.
What IOSCO/CPSS Says
In light of all this, the International Organization of Securities Commissioners (IOSCO) and the BIS Committee on Payment and Settlement Systems (CPSS) have jointly issued a consultation document they call “Recovery of Financial Market Infrastructures.” In the introduction they say, “‘Recovery’ concerns the ability of a Financial Market Infrastructure (FMI) to recover from a threat to its viability and financial strength so that it can continue to provide its critical services without requiring the use of resolution powers by authorities. Recovery therefore takes place in the shadow of resolution.” In other words, this document addresses the worst of all worlds for market participants.
The report spends the first 10 of its 23 pages talking about recovery planning, certainly an important requirement. But then the report gets into recovery tools, and here’s where it really gets interesting. In Section 3.2 the report says, “FMIs can be exposed to legal, credit, liquidity, general business, custody, investment and operational risks. … The manifestation of the risks may have different causes and may also result in different types of failure scenarios.”
But the most startling section of the report is Section 3.5, “Tools to allocate uncovered losses caused by participant default.” This gets into the very difficult subject of who pays when a large default exhausts the CCP’s resources. Things get really interesting in Section 3.5.14, where the report says:
“An important example of a position-based loss allocation recovery tool is variation margin haircutting by CCPs. When haircutting variation margin, the CCP reduces pro rata the amount it is due to pay participants with in-the-money (net) positions, while continuing to collect in full from those participants with out-of-the-money (net) positions… Where a CCP does not have a direct contractual relationship with indirect participants (ie clients of direct participants [or customers of FCMs]), the impact on such indirect participants will depend upon their contractual arrangements with their respective direct participants.”
So if you have a winning position with the wrong CCP – one that might clear for a big loser or two – you might not get some of your winnings.
The final wave of the swaps clearing mandate will hit in September. But entering into a clearing agreement doesn’t mean swaps trading will be risk-free, as CCPs hold the potential to be an extraordinarily risky part of the market.
And this vulnerability isn’t restricted to VM. In a paragraph that has garnered lots of publicity, Section 3.5.19 says:
“Initial margin haircutting could be limited to the initial margin of direct participants. On the other hand, the tool could be applied to the margin of all participants (direct and indirect) providing this is consistent with the laws and regulations to which the CCP is subject and the rest of the CCP’s rules. Like variation margin haircutting, even where the CCP applies margin haircuts only to direct participants, the contractual arrangements between direct participants and indirect participants may cause the haircutting to have an impact on indirect participants.” (Emphasis added)
So if a market participant has a winning position, but clears at a CCP that is in trouble, not only could the market participant’s VM be withheld, its IM could also disappear into the financial black hole. Not a pretty thought!
Some Legal Advice
So it is especially welcome that attorney Sherri Venocur has written an informative article called, “What Customers Should Look Out For in FCM Clearing Agreements.” In one section, she cautions:
“Section 724(a) of Dodd-Frank restricts an FCM’s use of its customer’s collateral and specifies the instruments into which an FCM may invest its customer’s collateral. Nonetheless, most Clearing Agreements give the FCM the right to rehypothecate collateral and otherwise to deal with it as though it were the FCM’s own property… Thus, customers should push for the inclusion in the Clearing Agreement of a provision containing language similar to that in the proposed rule, and it would seem unreasonable for an FCM not to agree to include it.”
Another point Ms. Venocur makes is that banks that are FCMs often have many affiliated entities that perform related functions, such as trading, lending, or money transfer. A clearing customer may have relationships with some of those affiliates, so, she says:
“It is most important for the customer to understand the possible consequences of [any] cross-affiliate provisions in light of the customer’s particular circumstances. To that end, the customer should: (i) review the customer’s existing relationships with the Bank and inquire about anticipated future relationships; (ii) review all documents relating to such relationships; and (iii) based on this review, (A) understand what actions the Bank can take with respect to the customer or its property in the event the customer defaults or another circumstance occurs that gives the Bank the right to take certain actions (either specified or described broadly in the documents) and (B) understand what remedies are available to the customer in the event the Bank breaches its obligations under its various agreements with the customer or the customer otherwise wishes to terminate one or more relationships with the Bank.”
In conclusion, Ms. Venocur says:
“The implementation of Dodd-Frank and the regulations promulgated thereunder marks a radical change in the way OTC derivatives are executed, documented and implemented. While ISDA Master Agreements continue to be required, customers also need to execute Clearing Agreements with FCMs so that they can enter into derivative transactions that are subject to the mandatory clearing requirement. It is essential that customers understand the risks within Clearing Agreements and negotiate these agreements with their FCMs in order to reduce or at the very least, to manage, such risks.”
August 14, 2013 by 
Carl A R Weir's Blog 